Market Bubbles

Proponents
of market irrationality have pointed to market bubbles as a primary exhibit in
their case against efficient markets. Through the centuries, markets have
boomed and busted, and in the aftermath of every bust, irrational investors
have been blamed for the crash. As we will see in this section, it is not that
simple. You can have bubbles in markets with only rational investors, and assessing
whether a bubble is due to irrational investors is significantly more difficult
than it looks from the outside.

A Short History of Bubbles

As
long as there have been markets, there have been bubbles. Two of the earliest
bubbles to be chronicled occurred in the 1600s in Europe. One was the amazing
boom in prices of tulip bulbs in Holland that began in 1634. A single Tulip
bulb (Semper Augustus was one variety) sold for more than 5000 guilders (the
equivalent of more than $ 60000 today) at the peak of the market. Stories
abound, though many of them may have been concocted after the fact, of
investors selling their houses and investing the money in tulip bulbs. As new
investors entered the market in 1636, the frenzy pushed up bulb prices even
more until the price peaked in early February. Figure 7.11 presents the price
of one type of bulb (Switzers) in January and February of 1637.[1]

Note that the price peaked on February 5, 1637, but an investor
who bought tulip bulbs at the beginning of the year would have seen his or her
investment increase almost 30 fold over the next few weeks.

A
little later in England, a far more conventional bubble was created in
securities of a firm called the South Seas Corporation, a firm with no assets
that claimed to have the license to mint untold riches in the South Seas. The
stock price was bid up over the years before the price plummeted. The crash, which
is described in vivid detail in Charles Mackay’s classic book titled
“Extraordinary Delusions and the Popular Madness of Crowds”, left many
investors in England poorer.[2]

Through
the 1800s, there were several episodes of boom and bust in the financial
markets in the United States and many of these were accompanied by banking
panics.[3]
As markets became broader and more liquid in the 1900s, there was a renewed
hope that liquidity and more savvy investors would make bubbles a phenomenon of
the past, but it was not to be. In 1907, J.P. Morgan had to intervene in financial
markets to prevent panic selling, a feat that made his reputation as the
financier of the world. The 1920s saw a sustained boom in U.S. equities and
this boom was fed by a number of intermediaries ranging from stockbrokers to
commercial banks and sustained by lax regulation. The crash of 1929
precipitated the great depression, and created perhaps the largest raft of
regulatory changes in the United States, ranging from restrictions on banks
(the Glass-Steagall Act) to the creation of a Securities Exchange Commission.

The period after the second world
war ushered in a long period of stability for the United States, and while
there was an extended period of stock market malaise in the 1970s, the bubbles
in asset prices tended to be tame relative to past crashes. In emerging
markets, though, bubbles continued to form and burst. In the late 1970s,
speculation and attempts by some in the United States to corner the precious
metals markets did create a brief boom and bust in gold and silver prices. By
the mid-1980s, there were some investors who were willing to consign market
bubbles to history. On October 19, 1987, the U.S. equities market lost more
than 20% of their value in one day, the worst single day in market history,
suggesting that investors, notwithstanding technological improvements and more
liquidity, still shared a great deal with their counterparts in the 1600s. In
the 1990s, we witnessed the latest in this cycle of market bubbles in the
dramatic rise and fall of the “dot-com” sector. New technology companies with
limited revenues and large operating losses went public at staggering prices
(given their fundamentals) and kept increasing. After peaking with a market
value of $ 1.4 trillion in early 2000, this market too ran out of steam and lost
almost all of this value in the subsequent year or two. Figure 7.12 summarizes
the Internet index and the NASDAQ from 1994 to 2001:

The chart again has the makings of a bubble, as the value of
the index internet index increased almost ten fold over the period, dragging
the tech-heavy NASDAQ up with it.

Rational Bubbles?

A
rational bubble sounds like an oxymoron, but it is well within the realms of
possibility. Perhaps the simplest way to think of a rational bubble is to
consider a series of coin tosses, with a head indicating a plus day and a tail
a minus day. You would conceivably get a series of plus days pushing the stock
price above the fair value, and the eventual correction is nothing more than a
reversion back to a reasonable value. Note too that it is difficult to tell a
bubble from a blunder. Investors in making their assessments for the future can
make mistakes in pricing individual assets, either because they have poor
information or because the actual outcomes (in terms of growth and returns) do
not match expected values. If this is the case, you would expect to see a surge
in prices followed by an adjustment to a fair value. In fact, consider what
happened to gold prices in the late 1970s. As inflation increased, many investors
assumed (incorrectly in hindsight) that high inflation was here to stay and
pushed up gold prices accordingly. Figure 7.13, which graphs gold prices from
1970 to 1986, looks very much like a classic bubble, but may just indicate our
tendencies to look at things in the rear view mirror, after they happen.

Note that the surge in gold prices closely followed the
increase in inflation in the late 1970s, reflecting its value as a hedge
against inflation. As inflation declined in the 1980s, gold prices followed. It
is an open question, therefore, whether this should be even considered a
bubble.

Bubble or Blunder: Tests

There
are some researchers who argue that you can separate bubbles from blunders by
looking at how prices build up over time. Santoni and Dwyer (1990), for
instance, argue that you need positive two elements for a bubble – positive serial
correlation in returns and a delinking of prices and fundamentals as the bubble
forms. They test the periods prior to 1929 and 1987 crashes to examine whether
there is evidence of bubbles forming in those periods. Based upon their
analysis, there is no evidence of positive serial correlation in returns or of
a reduction in the correlation between prices and fundamentals (which they
define as dividends) in either period. Therefore, they argue that neither
period can be used as an example of a bubble.

While
there is truth to the underlying premise, these tests may be too weak to
capture bubbles that form over long periods. For instance, Santoni and Dwyer’s
conclusion of no serial correlation seems to be sensitive to both the time periods
examined and the return interval used. In addition, detecting a delinking of
prices and fundamentals statistically may be difficult to do if it happens
gradually over time. In short, these may be useful indicators but they are not
conclusive.

Bubbles: From Inception to Crash

One
or the more fascinating questions in economics examines how and why bubbles
form and what precipitates their bursting. While each bubble has its own
characteristics, there seem to four phases to every bubble.

Phase 1: The Birth of the Bubble

Most
bubbles have their genesis in a kernel of truth. In other words, at the heart
of most bubbles is a perfectly sensible story. Consider, for instance, the
dot.com bubble. At its center was a reasonable argument that as more and more
individuals and businesses gained online access, they would also be buying more
goods and services online. The bubble builds as the market provides positive
reinforcement to some investors and businesses for irrational or ill-thought
out actions. Using the dot.com phenomenon again, you could point to the
numerous start-up companies with half-baked ideas for e-commerce that were able
to go public with untenable market capitalizations and the investors who made
profits along the way.

A
critical component of bubbles building is the propagation of the news of the
success to other investors in the market, who on hearing the news, also try to
partake in the bubble. In the process, they push prices up and provide even
more success stories that can be used to attract more investors, thus providing
the basis for a self-fulfilling prophecy. In the days of the tulip bulb craze,
this would have had to be word of mouth, as successful investors spread the
word, with the success being exaggerated in each retelling of the story. Even
in this century, until very recently, the news of the success would have
reached investors through newspapers, financial newsmagazines and the occasional
business show on television. In the dot.com bubble, we saw two additional
phenomena that allowed news and rumors to spread even more quickly. The first
was the internet itself, where chat rooms and web sites allowed investors to
tell their success stories (or make them up as they went along). The second was
the creation of cable stations such as CNBC, where analysts and money managers
could present their views to millions of investors.

Phase 2: The Sustenance of the Bubble

Once
a bubble forms, it needs sustenance. Part of the sustenance is provided by the
institutional parasites that make money of the bubble and develop vested interests
in preserving and expanding the bubbles. Among these parasites, you could
include:

Investment
banks: Bubbles in financial markets bring with them a number of
benefits to investment banks, starting with a surge in initial public
offerings of firms but expanding to include further security issues and
restructurings on the part of established firms that do not want to be
shut out of the party.

Brokers
and analysts: A bubble generates opportunities for brokers and
analysts selling assets related to the bubble. In fact, the ease with
which investors make money as asset prices go up, often with no
substantial reason, relegates analysis to the backburner.

Portfolio
Managers: As a bubble forms, portfolio managers initially watch in
disdain as investors they view as naēve push up asset prices. At some
point, though,, even the most prudent of portfolio managers seem to get
caught up in the craze and partake of the bubble, partly out of greed and
partly out of fear.

Media:
Bubbles make for exciting business news and avid investors. While this is
especially noticeable in the dot.com bubble, with new books, television
shows and magazines directly aimed at investors in these stocks, even the
earliest bubbles had their own versions of CNBC.

In addition to the institutional
support that is provided for bubbles to grow, intellectual support is usually
also forthcoming. There are both academics and practitioners who argue, when confronted
with evidence of over pricing, that the old rules no longer apply. New
paradigms are presented justifying the high prices, and those who disagree are
disparaged as old fashioned and out of step with reality.

Phase 3: The Bursting of the Bubble

All
bubbles eventually burst, though there seems to be no single precipitating
event that causes the reassessment. Instead, there is a confluence of factors
that seem to lead to the price implosion. The first is that bubbles need ever
more new investors (or at least new investment money) flowing in for
sustenance. At some point, you run out of suckers as the investors who are the
best targets for the sales pitch become fully invested. The second is that each
new entrant into the bubble is more outrageous than the previous one. Consider,
for instance, the dot.com bubble. While the initial entrants like America
Online and even Amazon.com might have had a possibility of reaching their
stated goals, the new dot.com companies that were listed in the late 1990s were
often idea companies with no vision of how to generate commercial success. As
these new firms flood the market, even those who are apologists for high prices
find themselves exhausted trying to explain the unexplainable.

The
first hint of doubt among the true believers turns quickly to panic as reality
sets in. Well devised exit strategies break down as everyone heads for the exit
doors at the same time. The same forces that created the bubble cause its
demise and the speed and magnitude of the crash mirror the formation of the
bubble in the first place.

Phase 4: The Aftermath

In
the aftermath of the bursting of the bubble, you initially find investors in
complete denial. In fact, one of the amazing features of post-bubble markets is
the difficulty of finding investors who lost money in the bubble. Investors
either claim that they were one of the prudent ones who never invested in the bubble
in the first place or that they were one of the smart ones who saw the
correction coming and got out in time.

As
time passes and the investment losses from the bursting of the bubble become
too large to ignore, the search for scapegoats begins. Investors point fingers
at brokers, investment banks and the intellectuals who nurtured the bubble,
arguing that they were mislead.

Finally,
investors draw lessons that they swear they will adhere to from this point on.
“I will never invest in a tulip bulb again” or “I will never invest in a
dot.com company again” becomes the refrain you hear. Given these resolutions, you may wonder why price bubbles
show up over and over. The reason is simple. No two bubbles look alike. Thus,
investors, wary about repeating past mistakes, make new ones, which in turn
create new bubbles in new asset classes.

Upside versus Downside bubbles

Note
that most investors think of bubbles in terms of asset prices rising well above
fair value and then crashing. In fact, all of the bubbles we have referenced from
the tulip bulb craze to the dot-com phenomenon were upside bubbles. But can
asset prices fall well below fair market value and keep falling? In other
words, can you have bubbles on the downside? In theory, there is no reason why
you could not, and this makes the absence of downside bubbles, at least in the
popular literature, surprising. One reason may be that investors are more likely
to blame external forces – the bubble, for instance – for the money they lose
when they buy assets at the peak of an upside bubble and more likely to claim the
returns they make when they buy stocks when they are at the bottom of a
downside bubble as evidence of their investment prowess.

Another may be that it is far
easier to create investment strategies to take advantage of under priced assets
(in a downside bubble) than it is to take advantage of over priced assets. With
the former, you can always buy the asset and hold until the market rebounds.
With the latter, your choices are both more limited and more likely to be time
limited. You can borrow the asset and sell it (short the asset), but not for as
long as you want – most short selling is for a few months. If there are options
traded on the asset, you may be able to buy puts on the asset though, until
recently, only of a few months duration. In fact, there is a regulatory bias in
most markets against such investors who are often likely to be categorized as
speculators. As a consequence of these restrictions on betting against
overpriced assets, bubbles on the upside are more likely to persist and become
bigger over time, whereas bargain hunters operate as a floor for downside
bubbles.

A Closing Assessment

Based
upon our reading of history, it seems reasonable to conclude that there are
bubbles in asset prices, though only some of them can be attributed to market
irrationality.Whether investors
can take advantage of bubbles to make money seems to be a more difficult
question to answer. Part of the reason for the failure to exploit bubbles seems
to stem from greed –even investors who believe that assets are over priced want
to make money of the bubble – and part of the reason is the difficulty of
determining when a bubble will burst. Over valued assets may get even more over
valued and these overvaluations can stretch over years, thus imperiling the
financial well being of any investor who has bet against the bubble. There is
also an institutional interest on the part of investment banks, the media and
portfolio managers, all of whom feed of the bubble, to perpetuate the bubble.

[1]
This graph is based upon data provided by Garber(1990) in “Crashes
and Panics: The lessons of History”,
Dow Jones Irwin. It should be
pointed out that he does not believe that the pricing of tulip bulbs was
irrational for much of the period.

[2]To get a flavor of financial markets in England at
the time of the South Sea bubble, you should look at “Conspiracy of Lies”, a
novel set in the era by David Liss. Edward Chancellor’s
“Devil takes the hindmost” provides historical perspective on the bubble.

[3]
The crash of 1873 was precipitated by the failure of firm called Jay Cooke, a
financial-service firm in Philadelphia. The New York Stock Exchange was closed
for ten days and several banks closed their doors in the
aftermath.